The RBA SHOULD NOT Lower Its Inflation Target

Originally published by AMP Capital

Investment markets and key developments over the past week

• Share markets had a bit of a messy ride over the last week – first falling on worries about Turkey and then bouncing back to varying degrees on news of new US/China trade talks. This saw Australian and US shares up, Japanese shares flat but Eurozone and Chinese shares down. Bond yields were little changed although they are back above 3% in Italy as Italian budget negotiations come into focus. Commodity prices fell further not helped by ongoing US dollar strength on the back of Turkish worries and this also contributed to further fall in the Australian dollar.

• Worries about contagion from the Turkish crisis remain. Turkey got into this mess largely thanks to populist “growth at any cost policies” and its leader’s populist rejection of higher interest rates and an international bailout (for now) and refusal to make up with the US is helping perpetuate it. Financial assistance from Qatar will help but is unlikely to be enough. While Eurozone bank exposures to Turkey aren’t big enough to cause a major problem (they are mostly small relative to balance sheets and are likely to have been hedged) and global trade exposure to Turkey isn’t big enough either to cause a major problem and most other emerging markets are in far better shape both economically and politically, financial contagion remains a risk for emerging markets – with Brazil and South Africa most at risk. After a 14% fall, emerging market shares are now quite cheap (with an average forward PE of 11 times), but they are likely to remain under pressure until contagion fears from vulnerable EMs (notably Turkey at present) stop, the $US stops rising, uncertainty regarding Chinese growth fades and the trade war threat ends. Speaking of which…

• …at last some good news on the US/China trade front with China sending a delegation to the US at the end of this month for renewed trade talks at the invitation of the US. Investors would be wise to be sceptical as to whether anything can be achieved quickly enough to head off US tariffs on another $US200bn of imports from China next month given that the May agreement was quickly trashed by Trump, that these negotiations are occurring at a low level officially and that both sides have dug in. Then again as we saw with Europe you never know, and most commentators seem to be sceptical of any break through and its in both sides interest to find a negotiated solution.

• While we remain of the view that the conditions are not in place for a major bear market, we are now coming into the seasonally weak August-October period for shares and there are a lot of uncertainties around (Turkey/emerging markets, trade war threats, the Italian budget negotiations, ongoing Fed rate hikes, the Mueller inquiry and the US mid-term elections) all of which have the potential to trigger volatility and weakness in the next few months. This will likely impact both global and Australian shares.

• Should the RBA lower its inflation target from 2-3% to say 1-2%? Short answer: NO! This debate comes up regularly and back in 2007-08 when inflation was around 4% some were arguing that the target should be raised. But lowering the target would be a bad move: it would give the impression that the RBA is not committed to its inflation target and just changes the goal posts when it’s not meeting it; a lower target would provide little buffer to slipping into deflation; it would mean less flexibility to take real interest rates negative when needed in a recession; and the consumer price index overstates inflation by around 2% or so given the problems in measuring quality change so running 1-2% inflation would imply actual deflation much of the time. If the argument is that by cutting the target the RBA can then declare victory on inflation and raise rates, then it’s a nonsense because by raising rates prematurely it would knock the economy and result in even lower inflation. If anything other countries should really be raising their inflation targets to 2-3% rather than RBA cutting its target.

• August 17th marks the 41st anniversary of the day I and others in this time zone learned Elvis had apparently left the building. Back 50 years ago in 1968 Elvis had been working on what has become known as his Comeback Special. After years making lightweight movies (which I actually like, especially Live a Little Love a Little and Change of Habit which came in 1969) Elvis was feeling nervous. The Colonel wanted to end the special which aired on NBC on 3rd December 1968 with Christmas carols. But Elvis wanted something more relevant to the times so they came up with If I Can Dream - perhaps the most powerful social commentary song Elvis ever produced. It was recorded in June 1968 just two months after Martin Luther King’s assignation in Memphis and the song references King’s words. The Elvis in white suit delivery that wrapped the Special is well-known and is here in original form but it was also sung by Elvis in a black leather jumpsuit and it’s here with an updated collaboration with the Royal Philharmonic Orchestra.

Major global economic events and implications

• US economic data was mostly solid. Retail sales rose strongly in July, industrial production was weaker than expected but June was strong, jobless claims remain ultra low, small business optimism is very strong but while manufacturing conditions in the New York region strengthened in August they fell in the Philadelphia region. Housings starts rose less than expected in July, but home builder conditions remain strong.

• Eurozone GDP growth for the June quarter was revised up to 0.4% qoq or 2.2% yoy but remains down from last year’s pace.

• Chinese data is consistent with a softening in growth. Credit, retail sales and investment all slowed slightly in July and industrial production growth was unexpectedly flat. While the slowdown is not dramatic it suggests that the cut back in shadow lending and uncertainty around trade is weighing and supports the case for further policy stimulus.

Australian economic events and implications

• Yet again Australian data was a mixed bag over the last week with strong jobs data but continuing weak wages growth and somewhat softer readings on business conditions and consumer confidence. While employment fell in July this was after a strong June which itself was revised up and full-time jobs growth remained strong in July. Unemployment fell but this reflected a fall in participation. While annual employment growth is off its highs jobs leading indicators continue to point to solid jobs growth ahead. However, wages growth remained soft in the June quarter at 2.1% year on year and were it not for a faster increase in minimum wages it would still be stuck at just 1.9%. While strong employment is good news it’s not enough to move the RBA from being on hold given ongoing high levels of underemployment, weak wages growth, falling house prices, etc. We remain of the view that the RBA will be on hold out to 2020 and there is still a significant chance that the next move will be a cut rather than a hike. RBA Governor Lowe’s Parliamentary Testimony did nothing to change our view on this.

• The June half Australian earnings reporting season is now around 35% done and so far so good. 48% of results have surprised on the upside compared to a norm of 44%, the breadth of profit increases is high with 83% reporting higher profits than a year ago compared to a norm of 66%, 89% have increased their dividends or held them constant and 64% of companies have seen their share price outperform the market on the day results were released. That said its often the case that the quality of results tails off in the last two weeks of the reporting season so don’t get too excited just yet. 2017-18 earnings growth are on track to come in around 9%, with resources earnings up 25% thanks to solid commodity prices and rising volumes and the rest of the market seeing profit growth of around 5%.

What to watch over the next week?

• In the US, expect the minutes from the Fed’s latest meeting (Wednesday) to confirm that it remains on track for another rate hike next month. The Kansas Fed’s Jackson Hole central bankers’ symposium (Thursday-Saturday) will also be watched for any clues on monetary policy, with Fed Chair Powell confirmed as a speaker. On the data front expect a modest rise in existing home sales (Wednesday), a continued increased in home prices and August business conditions PMIs (both Thursday) to remain solid at around 55-56 and July durable goods orders (Friday) to show a continuing rise.

• Eurozone business conditions PMIs (Thursday) will be watched for any improvement from their recent levels around 54-55.

• Japanese inflation data is expected to show a slight improvement in inflation excluding fresh food and energy to around 0.4% yoy, but it won’t be enough to move the Bank of Japan away from its ultra-easy monetary policy.

• In Australia the minutes from the RBA’s last board meeting (Tuesday) are likely to show the Bank remaining comfortably on hold. June quarter construction data is expected to show another modest rise and skilled vacancy data (both due Wednesday) will also be released.

• The Australian June half earnings reporting season will see its busiest week with 70 major companies reporting including Woolworths (AX:WOW), Fortescue (AX:FMG) and Primary Health Care (AX:PRY) (Monday), Amcor (AX:AMC), Oil Search (AX:OSH) and BHP Billiton (AX:BHP) (Tuesday), Seven Group (AX:SVW), Worley Parsons (OTC:WYGPY) and Coca-Cola Amatil (AX:CCL) (Wednesday), Qantas (AX:QAN), South32 (AX:S32) and Nine (AX:NEC)(Thursday) and MYOB (AX:MYO) (Friday). Dividend growth is likely to remain solid.

Outlook for markets

• While we see share markets being higher by year end as global growth remains solid helping drive good earnings growth and monetary policy remains easy, we are likely to see ongoing bouts of volatility and weakness as the US driven trade skirmish with China could get worse before it gets better and as worries remain around the Fed, President Trump in the run up to the US mid-term elections, China, emerging markets and property prices in Australia. The August to October period is well known for share market falls and volatility.

• Low yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.

• Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning.

• National capital city residential property prices are expected to slow further as Sydney and Melbourne property prices continue to fall, but Perth and Darwin bottom out, and Adelaide, Canberra and Brisbane see moderate gains.

• Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

• We continue to see the Australian dollar trending down to around $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory as the US economy booms relative to Australia. Solid commodity prices should provide a floor for the Aussie dollar though in the high $US0.60s. The fall in the Aussie dollar on the back of Turkish contagion fears highlights that being short the Aussie and long foreign exchange is a good hedge against threats to the global outlook.

All the best for a dope weekend.